The following invention relates to a method and system for hedging against the risk of fluctuations in foreign exchange rates and, in particular, for providing a hedge against foreign exchange risk associated with security transactions.
There has been a rapid increase in the number of securities of foreign companies that are traded in the U.S. financial markets, such as the New York Stock Exchange, the American Stock Exchange, NASDAQ and the over-the- counter markets. In addition, there has been an increasing interest on the part of U.S. investors regarding securities traded on foreign markets. These trends demonstrate a shift to a global cross-border trading network in which investors can trade in foreign securities as easily as trading in domestic securities.
A potential impediment to the establishment of a global trading network is that investors that trade in instruments in currencies other than their home currency will be exposed to the risks associated with the change in foreign exchange rates. For example, if a Japanese investors purchases 100 shares of XYZ corp. trading on the NASDAQ for $10 a share, the transaction would cost the investor 100,000 yen, assuming the exchange rate was 100 yen to the dollar at the time of the transaction. If the investor decides to sell the XYZ shares at a time when the exchange rate is 95 yen to the dollar, the investor would incur a 5% loss associated with the fluctuation in the foreign exchange rate. This added risk may deter an investor from trading in a foreign security.
There are existing techniques for protecting against the fluctuation of foreign exchange risks. For example, a buyer of an FX call option has right to purchase a specified amount of foreign currency at a specified exchange rate at a specified time. By purchasing an FX option for the currency the investor wishes to receive upon selling the foreign security, the investor can minimize the risk associated with the fluctuation of that currency.
FX options, however, are unsuitable for providing insurance against foreign exchange risks associated with a security transaction for several reasons. First, the use of FX options would add a layer of complexity to the security transaction by requiring the investor to be familiar with option investing and the use of calls and puts to hedge a position. Also, FX options are typically for fixed amounts of currency, for e.g. $100,000, and do not generally match the amount of currency risk associated with a typical securities transaction (in which the average order size in securities transaction is $15,000). Furthermore, the strike prices of FX options for a particular currency pair are predefined by the foreign exchange market makers and will often not match the exact exchange rate at which a specific securities transaction took place. In addition, FX option are normally “European style” in which case the premium does not strictly follow the exchange rate movements so that only partial FX risk protection is achieved. Also, European style options can only be exercised at expiry so they are not useful for protecting a specific equity position that may be terminated by the investor at any time. Finally, FX options are not easily purchased on-line so that equity investors will have to undergo a potentially time consuming process to hedge the FX risk associated with their foreign equity investment.
Another technique of hedging FX risks is the purchase of currency certificates. Currency certificates, however, also suffer from some of the same drawbacks as FX options including the introduction of added complexity to the securities transaction, standard certificate amounts that do not match the size of the hedge needed and predefined strike levels that do not match the exchange rate of the particular securities transaction.
A method for generating and executing an insurance policy for foreign exchange losses is disclosed in U.S. Pat. No. 5,884,274 (the “'274 patent”). The '274 patent teaches a method by which individual travelers can lock in favorable exchange rates for a particular foreign currency thereby eliminating the need to either purchase the foreign currency or an instrument denominated in the foreign currency, such as traveler's checks. Under the method of the '274 patent, an insurance policy is provided to the traveler based on the traveler's preferences including a specified currency, the amount of coverage and the period of coverage. The method then calculates the premium cost of the insurance policy based on the current exchange pair as well as an estimate of the volatility of the currency. Once the traveler purchases the foreign exchange policy for a particular exchange rate, that exchange rate is locked in for the amount of time and coverage specified in the policy. Thus, when the traveler makes a purchase in the foreign currency using a credit card, the exchange rate at the time of the purchase is compared to the exchange rate of the insurance policy to determine if the traveler is entitled to foreign exchange adjustment. Similarly, insurance coverage may be provided when the traveler withdraws the foreign currency from an ATM or from a bank.
Although the '274 patent discloses providing individuals an insurance policy against foreign exchange loss for a desired currency amount and for a desired period of time, the '274 patent does not teach a method for providing a hedge to investors against foreign exchange risks associated with the purchase of financial instruments, such as equity securities, in currencies other than their home currency. Furthermore, the method disclosed in '274 patent is not suitable for providing a hedge against foreign exchange losses associated with trading foreign equity securities. First, in the '274 patent, once the purchased coverage amount specified by the insurance policy is exceeded, the traveler is no longer protected against currency fluctuations. With respect to a purchase of an equity instrument, however, such a limitation in coverage amount is undesirable because the amount of coverage required fully to hedge against FX losses may increase in the event the security appreciates. Also, the insurance coverage provided by the method of the '274 patent is limited to the coverage period specified in the policy after which time the traveler's purchases are not covered. For a traveler wishing FX risk protection, such a limitation is not especially problematic because the traveler can generally specify a coverage period tied to a planned travel schedule. In contrast, investors in financial instruments cannot predict at what time in the future they will exit a particular position so a policy with a fixed coverage period will not be particularly useful.
Accordingly, it is desirable to provide a method and system by which investors that trade in financial instruments in foreign currencies can easily purchase a hedge against the foreign exchange risk associated with a particular trade.